Activity Based Cost Analysis

1. Activity Based Cost Analysis Review of key points Use in Customer Profitability Analysis

2. Activity Based Costing • All students should have already covered this but we shall quickly review the key points • What is it ? • How are costs calculated ? • How can it be used ? • We will do this fairly quickly and use question 21.18 to help our review

3. What is ABC ? • A costing methodology which recognises that costs usually arise because of certain activities • E.g. Number of deliveries of a product or number of production run set-ups needed • As different products consume these activities in different numbers this will affect their cost structures • ABC in practice involves identifying the key activities and the actions that drive these activities (and, therefore, drive costs)

4. Comparison with Traditional Costing • ABC does not assume all overhead costs are volume related • Traditional costing would usually use labour or machine hours as a single volume-related overhead recovery base • Result : • ABC tends not to overstate profitability of low-volume products/or understate profit of high-volume products • ABC gives a clearer indication of long-term variable costs • Especially relevant for long-term decisions • Basically ABC gives greater understanding about why costs are incurred

5. Product Costing Rationale • Deregulation of industries and increasing international competition has resulted in : • New entrants looking for profitable business • Existing firms need to reduce any cross-subsidisation • Could lose profitable business and be left with loss-making products • This has formed a strong rationale for more sophisticated and accurate costing systems

6. Other Uses of ABC • It has quickly become apparent that ABC has a range of other applications • The wider use of ABC has become known as Activity Based Cost Management • This can include incorporation into the budgeting process and into an ongoing process of understanding overall cost structures • The article on Customer Profitability states “the actual calculation of customer profitability amounts to an extensive ABC exercise” • Therefore, we should first make sure of the principles by working through question 21.18 which shows some of the range of applications for ABC

7. Customer Profitability AnalysisCPA • Customer rather than product as the cost object • We will use article and case study by Van Raaij et al to explore the issues • The additional reading from Atkinson et al is also quite helpful on this topic

8. Why are some customers less profitable? – Some examples • Customer makes frequent order changes • Customer orders special parts • Customer is difficult to please • There are lots of customer visits • Studies suggest that only 20% of customers are profitable! • This is based on the 80/20 rule – the article and case comes up with interesting figures

9. Activities • CPA needs to capture the costs of all the activities associated with moving the goods from the point of manufacture to the point where the trade customers assumes a legal ownership over them • It is important to see this as a starting point – as some of the literature will emphasise • The objective ultimately is to manage costs rather than just to measure them

10. Customer related activities include: • Invoicing • Design changes • Special packaging • Special deliveries • Late payments • Visits • Contacts

11. More customer related activities • Cost to acquire customers • After sales support • Conduct research • Maintain database • Advertising • These activities cut across the entire business and demands inputs from many functionally based sources of data.

12. Comparing customers • Challenge is to find characteristics of “High profit” and “Low profit” customers • i.e. not just find the profit levels but try to explain them as this could help future decisions • What steps can you make to improve profitability? • Again here, we should use the article/case to develop some conclusions

13. Using the article • We should use the attached article to help us appreciate some of the issues in this area • Otherwise this topic can seem a bit theoretical and basic • Questions for you to discuss : • What does research suggest about customer contribution to profits • What is the theoretical basis for CPA • What is learnt from the case study (also in general terms what is the value of case study research) • What are the key problems and conclusions that arise

14. Summary • Each customer is different • Each £ of revenue does not contribute equally to company’s profitability • Traditional costing systems not designed to provide information for CPA • Order size and frequency can affect costs • Post-sales support varies widely

15. Summary • In some cases it is easy to trace costs directly to customer • It is not always possible to avoid allocations • Need to meet customer expectations in cost-effective way • There is a past exam question in the handout which we can now use to help understand how this works in practice • Any future exam questions would include a strong focus on the sort of approach we have used for this topic